Diageo's Dilemma!

Published on Mon, May 04,2015 | 14:35, Updated at Tue, May 05 at 22:55Source : CNBC-TV18 | Watch Video :

Global spirits major Diageo is faced with a dilemma; to vote or not to vote for Vijay Mallya as Chairman of United Spirits. Here is the back story in brief.

DIAGEO’S DILEMMA!

PRIVATE AGREEMENTDiageo to support Vijay Mallya as Director & Chairman of USL - As long as he holds minimum 13,07,950 USL shares- Subject to certain conditions and in the absence of certain defaults

Doshi: Over 2012-2013, Diageo acquired a majority 55 percent stake in India’s leading spirits company USL. As part of the deal, Diageo committed to supporting outgoing promoter Vijay Mallya as Non-executive Director and Chairman of USL, as long as he holds a minimum 13,07,950 shares of USL, then representing 1 percent and subject to certain conditions.

DIAGEO’S DILEMMA!

FINANCIAL PROBLEM NUMBER 1Certain USL debtors claimed they advanced loans to UB Group entities They would repay USL only when UB group entities return their money

These debtors had confirmed balances in FY14Some of these debtors changed their story later

Agreements show lien was created on USL investments but released thereafter- USL Management claims it had no knowledge of the agreements!- USL Board says it had not approved any such agreements!

Soon after Diageo took over, USL’s revamped board and management came across several curious financial situations. This lead to several month delay in finalising accounts for FY14 and severe auditor qualifications to the final accounts. After confirming balances in FY14, in FY15 certain USL debtors claimed that they had advanced loans to certain alleged UB Group entities and that they would repay USL only when those UB Group entities returned their money. On 5th May, 2014 an alleged claimant wrote to USL, saying it had advanced a Rs 200 crore loan to Kingfisher Airlines against a lien on certain USL investments. While it withdrew its claim later on, USL upon investigation found that such a lien was sought to be created but without the company’s knowledge and without the approval of the USL Board.

INVESTIGATION FINDINGSBetween 2010 - 2013 funds were diverted to UB Group companies, in particular KFACertain transactions appear to have been undertaken to show lower exposure to UBHL

USL had various pre-existing loans, advances, deposits due from UBHL, Mallya’s holding company. In FY14, based on a previous board resolution and agreement, the dues were consolidated into an unsecured loan worth Rs 1,337 crore for an eight year period at 9.5 percent. These discoveries lead to large scale provisions for FY14 and prompted an internal investigation at USL that found that between 2010 and 2013, funds were diverted to UB Group companies, in particular, Kingfisher Airlines and that certain transactions were apparently undertaken to show a lower exposure to UBHL.

So, this week the United Spirits board asked Vijay Mallya to step down as Director and Chairman and in the event he declined to go, it has recommended a shareholder vote be held on his removal. If such a vote takes place, it is unclear how Diageo would vote its 55%, thanks to its agreement to support Mallya's chairmanship, and hence it is unclear if such a vote would in fact succeed. So, today to ponder over Diageo's dilemma, CNBC TV18’s Menaka Doshi is joined by Amarjeet Chopra, Prem Rajani and Rajat Sethi.

Doshi: I have already laid out in detail the financial improprieties that have come to light. How would you assess the gravity of these financial improprieties?

Chopra: The kind of provisions which have been made in this particular year are mind blowing and I think defies logic. To me more important will be to go back to earlier years, how these particular balances were confirmed at that particular point of time and how could the clean reports be obtained at that particular point of time, at least this year the company has come out clean making the provisions in respect thereof, but of course so far as the improprieties are concerned these are indeed grave, there is absolutely no doubt about it and particularly when you write off the amounts relating to your own related parties, this is something which is beyond one’s imagination. You try to create a provision of Rs 3,951 crore against advances related to your own companies, this is something which defies logic under all circumstances.

Doshi: It is not just the write offs and the provisioning. For instance the alleged claimant story that I told you about who claimed that there was certain lien against certain USL investments and the USL management and board said, we never knew such a lien was created, that points and if I may use the word, to fraud.

Chopra: To my mind this later on whatever stand the party had actually backed off, that seems to have been managed and if at all this particular lien was ever created and this could not have been created, and this could not have been created without the company’s resolution in any case and in that case it definitely does tantamount to fraud.

Doshi: So what do you think the ICAI ought to do now, because we have seen delayed accounts last year at USL, a forensic audit and an internal investigation thereafter, I suppose it is now up to the regulator in a sense to step in and look at what has taken place and interestingly, the firm that did the forensic audit which is PWC UK I am told seems to be in conflict with the fact that PWC itself was the auditor for USL with regards to the years under investigation?

Chopra: There is a definite conflict of interest and if somebody says today that the team which audited the accounts was different from the team which conducted the forensic audit, it has no meaning at all. To me there was no way that PWC could have conducted the forensic audit in this case because all these balances have continued over the years and if you are going to conduct forensic audit on your own opinion, that is not fair under any circumstances and it goes against the very basic principle of auditing as well as the corporate governance.

So far as your question of ICAI stepping in this concerned, to me, firstly the regulators which have to step in, are either SEBI or someone else, because the ICAI role will come in later. Whether the auditors were shown those papers or not, that is a different question but now once it has come to the knowledge that yes, there were certain papers which created the lien and these could have been only managed by way of a fraud, in that case it is for the SEBI to hold the case against the company, to make out a case against the company, make out a case against the people who were really interested in that kind of a transaction…

USL SAYS‘The inquiry prima facie revealed that between 2010 and July 2013,certain transactions entered into on behalf of the Company appear to have been undertaken to show a lower exposure of the Company to United Breweries (Holdings) Limited than that which actually existed at the relevant time, i.e., prior to July 2013.’

Doshi: When they discovered all these letters to claim that they had in turn loaned the money to UB Group companies, they said that these were the same debtors that had confirmed advances in previous years and it is only after March 2014, that this issue came up and hence the delay in reporting the accounts last year. So maybe that clears auditors from previous years, but on the flipside the USL management last week in its release to the exchange has said that between 2010 and 2013 certain transactions entered into on behalf of USL appear to have been undertaken to show a lower exposure of the company to United Breweries Holding Limited than that which actually existed at the relevant time, which is prior to July 2013. Now we have a couple of audit firms here which is PWC, Walker Chandiok that were involved in USL’s auditing over that time period. How do you report artificially lower exposure to group companies without the auditors finding out?

DIAGEO’S DILEMMA!

POWER AND DUTIES OF AUDITORS227 (1A) requires auditors to inquire (a) whether loans and advances made on the basis of security have been properly secured & the terms are not prejudicial to the interests of the company (b) whether transactions of the company which are represented merely by book entries are not prejudicial to the interests of the company

Companies Act, 1956

Chopra: I have no defense in that particular case for those firms, let me be very clear about it. What I am only trying to convey is that certain papers which you referred earlier, I am not sure whether the auditor’s had referred to it or not, but definitely one part is very clear, I have gone through the report of Grant Thornton in the last year and what I find is, there was a section on the anvil which is section 227 (1A) which talks of many things basically. One thing that it talks about section 227 (1A) is that if at all you had given certain advances, you had given certain deposits, but were not treated as advances, probably you definitely need to have a look at it.

What is really surfacing today is, that all these deposits or all this money which was advanced to these various subsidies was actually in the nature of loans and advances and it was not merely a deposit or an advance which is being shown that way, and if these were loans these were wrongly classified at that particular point of time and this actually doesn’t gel well, and then when later on you consolidate the entire debt, you say it will be recovered over a period of eight years and six year moratorium has also been granted. This is not done and at a rate of 9.5 percent the company has been borrowing at a much higher rate of interest. Today BSR qualifies on that, yes this is prejudicial to the company’s interest and Grant Thornton was absolutely silent on that particular issue.

DIAGEO’S DILEMMA!

USL SAYS‘…the directors noted that they had lost confidence in Dr. Vijay Mallya continuing in his role as a director and as chairman and therefore, the Board called upon Dr. Mallya to resign forthwith as a director and as the Chairman of the Board…’

‘ln the event Dr. Mallya declines to step down, the Board also resolved that it would recommend to the shareholders of the Company, the removal of Dr. Mallya as a director and as the Chairman of the Board.’

REMOVAL OF DIRECTOR169. (1) A company may, by ordinary resolution, remove a director…before the expiry of the period of his office after giving him a reasonable opportunity of being heard… (2) A special notice shall be required of any resolution, to remove a director under this section…

Special Notice Resolution: Need minimum 1% voting rights

“I do not intend to resign as a director of USL and shall pursue the contractual obligations with Diageo”- Vijay MallyaChairman, USL

Source: Mint

Doshi: Over the last year, United Spirits conducted an internal investigation that revealed diversion of funds to Mallya Group entities and an apparent attempt to show lower group exposure. Based on the various improprieties and legal violations, the USL Board says, it has lost confidence in Vijay Mallya continuing as Director and Chairman, and it has asked him to resign. If he declines to step down, the board says that it will recommend that shareholders remove Vijay Mallya as director. Now, the new Companies Act says, a director maybe removed before his term expires by an ordinary resolution but with special notice. That means such a resolution can only be proposed by shareholders holding at least one percent voting rights or shares of Rs five lakh in face value. The director must be given a reasonable opportunity of being heard. The question is who will move such a resolution against Vijay Mallya. As controlling shareholder, it ought to be Diageo, but Diageo claims a contractual obligation to support Vijay Mallya and Mallya ain't going down without a fight.

Rajani: Mallya might perhaps come up on two defense: a) as an agreement in which he may require Diageo to vote in favour of his continuing as a director, his vote against the resolution, b) the fact that Diageo knew about that entire past, during the diligence exercise. Now, those representations of Dr. Mallya perhaps may not hold really good at this shareholders meeting.

Doshi: Generally, in your experience, how easy or difficult is the removal of director process?

Rajani: So long as Dr. Mallya does not really go to the court of law, try to get some sort of injunction against this particular meeting, it is a fairly easy process. He might perhaps go to the court of law and try to get some form of injunction which courts seldom grant in these cases.

Doshi: Especially if the court has a chance to look at all these financial improprieties.

Doshi: With all these facts, very difficult for him to get any injunction from the company convening this meeting.

Doshi: Based on all these financial improprieties it might not be that easy for Mallya to get an injunction. Would that be fair to say? Let us put it that way.

Sethi: That’s certainly true. He would obviously like to rely on what the contractual commitment is.

Doshi: So now let us get to that contractual commitment.

Rajani: In fact, just a minute before that. Even without these particular facts, a court might still tell it is the shareholders' prerogative to keep a director or to remove a director. Assuming that no such irregularities are discovered, despite that if Dr. Mallya approached the court to stay his removal, the court would most likely say it is for the shareholders to decide whether to continue as a director or not. So, this certainly adds to the case. But, even without this.

Doshi: Even otherwise the court will vote in favour of shareholder democracy in that sense.

Rajani: Exactly.

Doshi: So, now we come to the many billion dollar question, what will Diageo do in these circumstances? Will it vote in favour of Mr. Mallya continuing as director and chairman because that is what its agreement with Vijay Mallya seems to indicate? Will it as the primary shareholder in United Spirits, the shareholder that controls the management and the board who have found all these financial improprieties, decide to vote against Mr Mallya because that is what the management would like or can it abstain because it has a conflicting agreement and it is the primary shareholder? In your opinion what will Diageo do?

Rajani: I really do not know what Diageo would do, that is for the management to decide. But what ideally they could do is, either rely on the agreement and say that because of the agreement they have to support Dr Mallya continuing as chairman and therefore they will vote against the resolution, which means the resolution fails and Dr Mallya continues as director. But that would be by and large going as per the contract. Considering that on Diageo has a 54 percent equity stake, they are almost in management, they have to even consider there is a law, there are irregularities, they have to remove him. They are certainly stuck between the, as you say, the rock and the hard place, if they vote for, if they vote against. If they vote against the removal of Dr Mallya, they are technically antagonising the public shareholders, they could face a class action in the US if there is such proceedings. The public may get up and say that you have reasons to remove him, but because of private contract which is not part of the articles of the company, you now cannot allow him to continue as director. On the other hand, if Diageo decides to vote for his removal, the only person who can sue him is Dr Mallya for breach of contract. Now whether breach of contract would amount to damages, it is subject to the governing laws and the detailed contract.

DIAGEO’S DILEMMA!

DIAGEO’S STATEMENT‘Diageo notes the recommendation of the USL board and will now consider its position under its agreements with Dr Mallya and United Breweries (Holdings) Limited in light of the inquiry report and materials provided to it.’

Doshi: Also because the contract says that the will support him as director and chairman, as long as he meets, subject to certain conditions and certain defaults not being triggered. We do not know what those conditions are or default clauses are and therefore we do not know is in fact these financial improprieties do trigger those default clauses. But in your opinion, would it be wiser for Diageo to risk a contractual suit in that sense, versus risking a shareholder action and regulatory action for being a majority shareholder that blocks the benefit of the company simply in order to honour a private agreement.

Rajani: I believe they should risk a breach of the contract. In fact there is no breach of a contract if you really ask me, there is no breach of the contact also. Most of them but not these contracts do have default provisions that will be governing law, there will be severability clause, they can rely on some of these provisions to say that their action toward in favour of the resolution, is because the law has ultimately prevail over the contract. So, I do not think they run the risk of really being sued for damages.

Doshi: What do you think Diageo would do or should do?

Sethi: If they feel strongly about their position under the contract, then and they feel that they have the basis under the contract to support a resolution for removing him, then obviously it is a no-brainer and they would go ahead with the shareholders' meeting. If on the other hand there is some ambiguity and we do not know what the meaning of what those precise conditions under the contract are. The contract refers to absence of certain defaults. So, presumably the contract goes into some detail on what those defaults are. We do not know whether at this point of time, it is possible to say that Mr Mallya has committed those defaults; it may be a bit premature to say that. He has been a Non-Executive Director on the board for a while. He has never been an Executive Director. So, if there is lack of clarity under the contract, then it may well be that Diageo has decided to place this whole matter in the public domain and wait for the regulators to take appropriate action, wait for momentum to build up and ultimately force Mr Mallya to step down.

Doshi: So, you are saying that this might be a convenient way out for Diageo to put all of this information in the public domain and say look, our hands are tied because we have a private agreement, but that does not mean that Institute of Chartered Accountants of India (ICAI), Securities and Exchange Board of India (SEBI), Ministry of Corporate Affairs (MCA) cannot take action and that action could very well force Mr Mallya to step down anyways, without it having it come to a vote which then puts us in a situation of dilemma, that is what you are saying?

Sethi: That is a possibility.

Rajani: Rather more graceful if Dr Mallya steps down, saves Diageo from that.

Doshi: Well he has chosen not to at least based on his public commentary of the last week and in fact he has raised the issue saying what kind of due diligence did Diageo claim to have done, if it could not discover all of this at the time when it was acquiring the company. And so he is indicating in some sense, that Diageo ought to have known about all of this. Why are they speaking up now?

Rajani: This is not an issue between Diageo and Dr Mallya. If that is, there were separate shareholders' agreement they can go for enforcement, misrepresentation, they can go for that contract. This is between the company and Dr Mallya. The public, the institutions, they have put the money in that company, facts have now been discovered. Whether Diageo knew or did not know about it is a secondary issue. Perhaps, Diageo may not be able to sue Dr Mallya for misrepresentation on damages. But knowing the management of the company as a public shareholder, we all need to know whether Dr Mallya should continue or not continue.

Doshi: Is there any legal provision under the Companies Act which in fact might say that Diageo, because of these circumstances, you are in conflict and therefore you ought to abstain, like for instance, how it plays out in related party transactions, you ought to abstain from this vote. Can they take cover under any such provision and not have to vote?

Rajani: The shareholders' agreement has not been made part of the articles of association, so it is a private treaty between Dr Mallya and Diageo. To that extent as a shareholder, Diageo can vote like any shareholder. Ideally they should vote.

Sethi: So on the abstention part of it, I am sure they are considering it, but I do not think… (Interrupted)

Doshi: Under what provisions can they choose to abstain?

Sethi: No, so it is for a shareholder to decide whether he wishes to vote yes or no, or abstain from voting. But the only reason… (Interrupted)

Doshi: But, even the abstention would be interpreted as a violation of its contractual commitments to Vijay Mallya, right? Because they have to actively support his chairmanship.

Sethi: That is right. That is the question for them to consider whether an abstention reduces the risk of a potential action from Mr Mallya and if there is some basis for that under the contract, then that is well an alternative which they would be considering.

Chopra: Irrespective of the agreement that they have privately, you see that is one part of it, but to me what is more important for Diageo today is to look at what is going to be the public's reaction and what is going to be the shareholders' reaction in the overall scenario. And irrespective of the fact that there has been a private agreement between the two, the law cannot say that, you cannot go against a man if the fraud has been established. I am not saying that it has been established as of now, I may not say so. But to me, there cannot be any prevention against it to Mr, there can be no safeguard to Mr Mallya against it. Once it is established that all these monies had been advanced to various parties and particularly they are related parties and those amounts are being written off today in one way or the other or are being provided for in one way or the other, to my mind, it really calls for some kind of an action and I do not think that the major shareholder today can sit on it and say no, we will wait for one year or two years; they must act and they have to act.

DIAGEO’S DILEMMA!

QARC: JUNE 2012SEBI established a Qualified Audit Report Review Committee to review qualified reports- Comprising representatives from ICAI, the stock exchanges and other stakeholder - May mandate restatement of accounts

Doshi: Maybe one way of looking at this is Diageo is hopeful that the regulators will act. I do not know why SEBI has not stepped in so far. These accounts were qualified last year. SEBI put in a whole mechanism to look at qualified accounts two years or three years ago and they seem to be sitting silent and pretty on this entire situation for the last several months. I do not know what the ICAI will do, it may drag its feet, it may not, and I suppose the MCA will also have a role to play in some fashion, right?

Rajani: Of course the regulators can take up, MCA can start the investigations, they have reasons to do on a 210, 213, they can start on the instigations but, is Diageo now buying time? 12 months, 18 months for the investigation to come up, and then take a position that it is the regulators who are asking for the removal?

DIAGEO’S DILEMMA!

COMPANIES ACT, 2013Section 210: Government may order investigation into affairs of companySection 213: Tribunal may order investigation into affairs of company based on based on application made by minimum 100 shareholders or those holding atleast 10% voting rights

Sethi: So, I think probably Diageo has already given this some thought before these events occurred. So, they have presumably a plan and a strategy to deal with this situation. It was unlikely that Mr Mallya would have stepped down on his own, because that would have meant an admission on wrong doing and I do not think he would want to do that. So, they presumably have their next steps ready.

Doshi: Which would be?

Sethi: One possibility is that if for example, more than SEBI, if for example, the ROC, the registrar of Companies, because if there are issues with falsification of accounts and we have reports which confirm that.

Sethi: And those reports have been, the press release says that those reports have been passed on to the, or will be passed on to the relevant regulators. Then we are not just looking at ROC, but we are looking at offences under the Indian penal Code (IPC) for falsification of accounts of criminal… then like Satyam pretty much. It depends on what the scale is, it could be criminal breach of trust, it could be cheating, it could be falsification of accounts and people could be prosecuted for those offences. And the other interesting implication of that could be that if the contract is talking about absence of certain defaults, if for example, Mr Mallya or any of his associates are charged with those offences, whether that would constitute a default of any sort.

DIAGEO’S DILEMMA!

USL SAYS‘The Board is not in a position to make any final determinations with regard to the roles of any individuals involved. The Board has therefore directed that the Company report such transactions to the authorities as required under applicable law.’

Doshi: Last words on this before I give it to Amarjeet Chopra, how do you think this moves forward?

Rajani: Diageo ideally should not wait more than three to four months, hoping that MCA or someone else will do the investigation, come with the report, which could be quite, six months to one year down the road. In my view they should call for the meeting, as a management, they will find judicial obligation to the public. If they don’t then of course they can… minority shareholders going to the court for mismanagement supporting Dr Mallya in a manner by not taking any concrete action after taking all the initiation of a forensic report and a PWC report, take all those things creating a hype and then not doing anything, are you really supporting Dr Mallya about it? So I suppose, as far as Diageo is concerned they should call for a meeting. Whether to vote or to abstain, I have already mentioned that part.

Doshi: Last word to you Mr Chopra. I come back to the gravity of these financial improprieties. Are we now looking at potential situations of fraud and maybe even criminal prosecution?

Chopra: I personally feel that the Serious Fraud Investigation Office should have adducted by now, because this report has been there for quite some time and based upon the auditor’s report itself, they should have adducted. I am really surprised why it has not happened so far.

DIAGEO’S DILEMMA!

FY14 AUDIT REPORTPending the completion of the inquiry… we are unable to conclude whether these instances can be termed as ‘fraud’ and whether there are other instances of a similar nature.- BSRUSL Auditor

The other point that I feel surprised about is that in the Companies Auditors Report Order (CARO), in para 21 of CARO, the auditors have fallen short of saying that it is a fraud, they say that the matter is under investigation. To me, to the extent the management has already provided for or written off the amounts in respect of such advances or loans which means it is an admission of fact by the management.

The management to my mind in its own way has admitted yes, there was a fraud to that particular extent and it automatically leads to another question, whether there was a falsification of accounts in the earlier years. The answer is yes. If we are providing for such a huge amount in respect of whether these are security deposits, whether these are trade receivables, whether these are other short term advances, whether these are advances to the related parties, you talk of any aspect in which there was debit balance and we have provided for or written of the amounts, to my mind there is an admission of fact by the management itself that in the earlier years, the falsification of the books or the falsification of accounts had actually taken place and it needs to be looked into and Serious Fraud Investigation Office, SEBI and other regulators must come into play as fast as possible.